Books rejection, related-party interest, subsidy-linked depreciation and ad hoc expense disallowance were all tested on commercial reasonableness.

Defects in stock and production records justified rejection of the books, but profit had to be re-estimated on the average gross profit rate of earlier accepted years rather than by a mechanical highest-rate approach. Interest paid to related persons was not excessive merely because it exceeded bank lending rates, as unsecured related-party borrowing could justify a higher commercial rate; relief was allowed by restricting disallowance to the extent above 18%. A subsidy tied to fixed capital investment in plant and machinery had to be reduced from the depreciable cost. Unsupported factory, telephone and vehicle-related claims also warranted a 10% ad hoc disallowance.

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Issues: (i) whether the books of account could be rejected under section 145(3) of the Income-tax Act, 1961 and the trading addition sustained, (ii) whether the interest paid to related persons was excessive under section 40A(2)(b) of the Income-tax Act, 1961, (iii) whether depreciation was to be reduced by the amount of subsidy received on purchase of plant and machinery, and (iv) whether the ad hoc disallowance out of factory expenses, telephone expenses and depreciation on vehicle expenses was justified.

Issue (i): whether the books of account could be rejected under section 145(3) of the Income-tax Act, 1961 and the trading addition sustained.

Analysis: The accounts suffered from defects in the maintenance of stock and production records, including absence of separate records for different qualities of seeds and lack of proper monthwise details of fuel and power consumption. Such deficiencies prevented proper verification of yield and production results. Rejection of the books was therefore justified. At the same time, profit estimation could not be made by mechanically adopting the highest yield or gross profit rate of earlier years; a reasonable average of earlier accepted gross profit rates was the proper basis.

Conclusion: The rejection of books under section 145(3) was upheld, but the trading addition was to be recomputed by applying the average gross profit rate of earlier accepted years.

Issue (ii): whether the interest paid to related persons was excessive under section 40A(2)(b) of the Income-tax Act, 1961.

Analysis: The rate of interest on loans from related persons could not be compared mechanically with bank lending rates, because bank loans involve security and guarantee requirements not present in loans from relatives. In such circumstances, a higher commercial rate could be reasonable. However, the fair rate was taken at 18% rather than the lower rate adopted by the authorities below.

Conclusion: The disallowance was deleted to the extent it exceeded a reasonable rate of 18%, and the issue was decided partly in favour of the assessee.

Issue (iii): whether depreciation was to be reduced by the amount of subsidy received on purchase of plant and machinery.

Analysis: The subsidy was linked to fixed capital investment and was calculated with reference to the cost of plant and machinery. The scheme therefore had a clear nexus with capital investment in the machinery, so the subsidy was required to be adjusted against the cost for depreciation purposes.

Conclusion: The disallowance of depreciation on the subsidy amount was upheld against the assessee.

Issue (iv): whether the ad hoc disallowance out of factory expenses, telephone expenses and depreciation on vehicle expenses was justified.

Analysis: Proper supporting records were not maintained, some payments were supported only by self-prepared vouchers, and personal use of telephone and vehicle could not be ruled out. In such circumstances, a partial disallowance of 10% was considered reasonable.

Conclusion: The ad hoc disallowance was upheld against the assessee.

Final Conclusion: The order sustained the rejection of books and the related estimations in part, granted limited relief on the interest disallowance, and otherwise upheld the additions and disallowances, resulting in a partly allowed appeal.

Ratio Decidendi: Where account defects prevent reliable verification of production and yield, books may be rejected and profit estimated on a reasonable average basis; interest to related parties may be tested against a fair commercial rate rather than bank lending rates; and a subsidy intrinsically linked to capital investment in plant and machinery may be deducted from cost for depreciation purposes.

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